Key Takeaways
- The steady descent of CLO 'AAA' credit spreads has caused resets and refinancings of U.S. CLOs to rebound impressively this year, nearly matching the record pace of 2021. However, the recent tumult in global markets and potential spread volatility could hinder the prospects of further spread tightening, reducing the likelihood of a historic U.S. reset/refi wave. That said, reset/refi activity has not wavered as of early/mid-August.
- In the U.S., the 2021 CLO vintage is the focal point of potential reset/refi issuance. If the reset/refi incentive for 2021 CLOs increases much further, 2024 reset/refi volume could approach, or even surpass, the record $252 billion full-year issuance that was priced in 2021.
- While 'AAA' spread tightening has spurred lively CLO new issuance activity in Europe, reset/refi deal flow has been comparatively quiet this year. Generally, this is because the majority of outstanding, refinance-reset-eligible European CLOs were priced with 'AAA' spreads much tighter than current levels.
- We present potential scenarios for U.S. and European CLO reset and refinancing volumes considering the universe of transactions outstanding in each market, how many of those transactions are eligible to be called, the incentives of CLO equity holders, and two paths of 'AAA' credit spreads.
Resets and refinancings (refis) of U.S. collateralized loan obligations (CLOs) have rebounded impressively in 2024, after coming to a near-halt in 2022 and 2023 amidst higher-for-longer interest rates and widening credit spreads. Reset/refi issuance totaled $140 billion through July 2024, which ranks second only to 2021--when CLO liability spreads compressed sharply amidst near-zero benchmark interest rates and robust investor appetite--resulting in $155 billion of issuance through July and record full-year volume of $252 billion. However, recent market volatility and the potential for "risk-off" sentiment taking hold among investors could affect CLO tranche spreads and alter the outlook for resets and refinancings over the remainder of this year.
The pace of resets and refinancings has not wavered so far, with over 30 U.S. transactions pricing in the first two weeks of August. But given the change in market sentiment, we thought now would be a good time to revisit our analysis of potential CLO reset and refinancing volumes using the same methodology as our previous publication on this topic (see "CLO Spotlight: Calling All CLOs! Or Not? Assessing The Potential Volume Of CLO Refinances And Resets," published Feb. 22, 2024). In this article, S&P Global Ratings presents potential scenarios for U.S. and European CLO reset and refinancing volumes considering the universe of transactions outstanding in each market, how many of those transactions are eligible to be called, and the incentives of CLO equity holders.
A Look Ahead At U.S. CLO Reset And Refinancing Volumes For The Remainder Of 2024: 2021 Vintage In Focus
Despite the steady descent of CLO 'AAA' tranche credit spreads through the first half of 2024, the recent tumult in global markets will likely hinder the prospects of continued spread tightening in the U.S. CLO market, at least while these conditions/views persist. Demand for CLO notes might soften if investors believe a recession could soon materialize, and likely Fed rate cuts on the horizon may reduce the allure of floating-rate debt. That said, if CLO tranche spreads remain stable or widen only moderately, we think 2024 will still likely be the second busiest year for refinances and resets in the history of the U.S. CLO market. Should spreads continue to tighten, full-year 2024 reset/refi volume could approach, or even surpass, the volume that was priced in 2021, although this is a less likely scenario.
From December 2023 to July 2024, the average U.S. broadly syndicated loan (BSL) CLO 'AAA' tranche spread to three-month SOFR fell by nearly 40 basis points (bps), renewing incentives for CLO managers and third-party equity holders to call outstanding deals. Middle-market CLO spreads have also fallen, and the basis between middle-market 'AAA' notes and BSL 'AAA' notes has narrowed significantly this year, to about 30 bps as of July 2024 from over 60 bps in late 2023.
Chart 1 below shows the distribution of CLO 'AAA' spreads and non-call period end dates that could affect individual call decisions in the U.S. (for European CLOs, see chart 5). While the overall cost of capital for the CLO's debt stack will drive the decision to refinance or reset the CLO (other than for a partial refinancing), we (consistent with the broader CLO market) often use the 'AAA' tranche spread as a proxy because the 'AAA' notes typically make up about two-thirds of the CLO capital stack by par value.
Chart 1
Most of the 2021 vintage (shown in red), which represents the largest cohort of outstanding CLOs and 60% of refinance-reset-eligible and incentivized transactions, is already "in-the-money". Still, it is important to consider that equity holders might not opt to reset or refinance a CLO until their "moneyness" (defined here as the outstanding 'AAA' spread minus current market average 'AAA' spread) is sufficient to cover costs and make the reset/refi economically advantageous. In other words, the benefit of lowering the CLO's interest expense should outweigh the potential costs of completing a reset/refi. These costs might include CLO arranger fees, collateral contributions to shore up the existing loan portfolio, and rating agency fees, for example.
U.S. market spread tightening and widening scenarios
In charts 2 and 3, we provide estimates of cumulative potential U.S. resets and refinancings through the end of 2024 under market spread tightening and widening scenarios. The tightening scenario assumes market 'AAA' spreads fall 15 bps by 2024 year-end, and the widening scenario assumes 'AAA' spreads rise 15 bps by year-end. Note that for the U.S. tightening scenario, we set middle-market 'AAA' spreads 30 bps higher than BSL 'AAA' spreads, and under the U.S. widening scenario, we set middle-market 'AAA' spreads 45 bps higher than BSL 'AAA' spreads, supposing that the basis between the two would widen under the credit stress that might accompany such a scenario.
Chart 2
Chart 3
2021 vintage a focal point
In the U.S., the 2021 vintage is the focal point of potential reset/refi issuance--a 15 bps drop in market spreads through year-end would render nearly all 2021 CLOs in the money, with a substantial proportion seeing moneyness greater than 15 bps. Under the tightening scenario, the count of cumulative reset/refi contenders would reach 1,305, which is more than any historical observation in our dataset. On the other hand, a 15 bps increase in market spreads would render most of the 2021 vintage out of the money, causing the count of cumulative reset/refi candidates to plummet to only 229 in December from 763 in August. Assuming stable market conditions and no movement in the current market average 'AAA' spread of 139 bps for the remainder of 2024, cumulative potential U.S. reset/refi volume would increase modestly to 805 CLOs by year-end, with the 2021 vintage only slightly in-the-money.
The analysis above incorporates a simplifying assumption: we assume that CLO equity holders are incentivized to exercise call options as soon as their CLO's outstanding 'AAA' spread exceeds the market average by any margin. As discussed, there are frictional costs such that, in practice, most CLO equity investors tend to exercise call options once their moneyness exceeds about 25 bps. The histogram below displays the distribution of 'AAA' tranche moneyness achieved by equity holders across a sample of 1,757 refinancings and resets in the U.S. The chart could be used to gauge the likelihood of a reset/refi given a particular CLO's degree of moneyness.
Chart 4
Based on the spreads of U.S. BSL CLOs priced in July, we estimate the median 'AAA' moneyness of the U.S. 2021 vintage stands at only 2 bps, far below the median realized moneyness of 25 bps in the histogram above. If spreads descend much lower in late 2024, the 2021 vintage could propel U.S. reset/refi issuance to new heights. In the event that spreads remain flat or widen modestly, the backend of 2024 is still poised for lively reset/refi activity. Nearly 80 CLOs issued at historically wide spreads in 2022 and 2023 will exit their non-call periods between August and December 2024, with clear incentives to call outstanding notes (i.e., median estimated moneyness of 66 bps, based on current market spreads). However, without considerable spread compression to bring the 2021 vintage fully "online", we think 2024 is unlikely to be a record-breaking year for U.S. CLO reset/refi volume.
European CLO Resets And Refinancings: Modest Volume Expected In Second Half Of 2024
Meanwhile, European CLO reset/refi deal flow has been comparatively quiet this year, posting $14 billion in volume through July versus $52 billion through July 2021. From December 2023 to July 2024, average European CLO 'AAA' spreads tightened more than in the U.S., with spreads falling 44 bps to three-month EURIBOR + 129 bps. While cheaper liability costs have helped reinforce new issue arbitrage and spur record year-to-date CLO formation in Europe, the impact on reset and refinancing activity has been less appreciable. Generally, this is because the majority of outstanding, refinance-reset-eligible European CLOs were priced with 'AAA' spreads over 20 bps tighter than current levels (see chart 5).
Chart 5
In Europe, there are relatively few outstanding and eligible CLOs currently incentivized to reset or refinance. Nevertheless, we expect to see several CLOs originally issued in 2022 and 2023 carry out a reset/refi later this year--about 20 will exit their non-call periods between August and December with a median estimated moneyness of 51 bps, based on current market spreads. Barring extraordinary spread tightening, 2024 European reset/refi issuance should not come close to the record $73 billion that was priced in full-year 2021.
European market spread tightening and widening scenarios
In charts 6 and 7, we provide estimates of cumulative potential European reset/refi volume through the end of 2024 under market spread tightening and widening scenarios. As we did for U.S. CLOs in charts 2 and 3 above, the tightening scenario presumes market 'AAA' spreads fall 15 bps by year-end, and the widening scenario assumes 'AAA' spreads rise 15 bps by year-end.
Chart 6
Chart 7
As discussed previously, most of the outstanding and reset/refinance-eligible European CLO universe is firmly out-of-the-money. Regardless of whether market spreads tighten or widen by 15 bps, potential reset/refi volume is little changed. Almost all the European CLOs that would be incentivized to reset/refi after 15 bps of spread tightening are already incentivized. These CLOs, which primarily belong to the 2022 and 2023 vintages, are also incentivized after spread widening of 15 bps, albeit with lesser moneyness. Should European market spreads hold steady at 129 bps through year-end, the cumulative count of reset/refi contenders would reach 34, exceeding the year-end CLO count in the widening scenario by only one.
Outlooks For U.S. And European CLO Reset/Refi Volume For Second Half Of 2024
While broader market conditions and potential credit spread volatility will continue to influence the pace of CLO refinance and reset activity in the second half of 2024, our analysis suggests that U.S. volume will rank second highest in the market's history, and European reset/refi volumes will remain modest due to the limited number of outstanding and eligible CLOs currently incentivized to reset or refinance.
This report does not constitute a rating action.
| Research Contacts: | Kohlton Dannenberg, Englewood + 1 (720) 654 3080; kohlton.dannenberg@spglobal.com |
| James M Manzi, CFA, Washington D.C. + 1 (202) 383 2028; james.manzi@spglobal.com | |
| Tom Schopflocher, New York + 1 (212) 438 6722; tom.schopflocher@spglobal.com | |
| Secondary Contacts: | Stephen A Anderberg, New York + (212) 438-8991; stephen.anderberg@spglobal.com |
| Daniel Hu, FRM, New York + 1 (212) 438 2206; daniel.hu@spglobal.com |
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